Rapidly escalating home prices have been a driving force behind the growth of “sub-prime” and “Alt-A” mortgages during the last number of years. These higher risk mortgages have recently been the mainstay of borrowers with good credit and a limited credit background. As home prices increased, one way to keep monthly payments under control was to use interest-only or payment-option mortgages, allowing zero or negative amortization of principal. After five years, large increases in payments were common. Still, these kinds of mortgages were the vehicle of choice for speculators intent on “flipping” property for a quick profit in an escalating real estate market. As long as real estate and home prices climbed, borrowers could refinance loans to prevent the ultimate catastrophe: default.

With prices falling, insufficient equity and market conditions, many borrowers face doubling mortgage payments. Eighty-five percent of borrowers with payment-option loans now owe more than they did when they originally took out the loan. 75 percent of these borrowers have been making the minimum payment. The banking industry has seen an eruption of default from speculators and borrowers that never should have been qualified for a loan.

Problems from lax lending practices went to seed last year with “sub-prime” loans, largely known in the market as 2/28s and 3/27s, which are adjustable rate loans with two to three year starter rates at between 6 and 9 percent with steep increases in payments after the initial term. These loans were commonly sold to families that were already struggling financially and encouraged to buy or refinance homes with loans they never had a realistic hope of maintaining for the life of the loan. A large number of these loans have been made to minority and working class neighborhoods. The loans performed well as long as home prices escalated and interest rates stayed low. Borrowers could refinance out of the loans before the increased payment hit. Refinancing action generated fees and prepayment penalties for brokers, lenders and investors. Brokers and mortgagers, in search of high volume aggressively marketed “sub-prime” loans to people with trouble credit or little experience. “Sub-prime” loans lacked income verification, loan to income ratios, high loan to value ratios and so on. This made selling the loans easy and money was good as commissions poured into the pockets of “commissioned salesmen”.

Since home prices are falling, many borrowers find themselves with less house value than mortgage value, much like the auto loan industry termed as “upside-down”. As borrowers stopped paying mortgages, many loan servicing companies mindlessly initiated foreclosure. Because of the sheer volume and the condition of the troubled market, mass foreclosures spell disaster for everyone involved. The FDIC, the Bush Administration and now the Federal Reserve have recently proposed and insisted on loan modification practices for the mortgage industry in the United States. Unfortunately, loan modifications are more difficult because most of the loans have been sold in lots as securities to investors. These securitized loans are managed by loan servicing companies with the mandate to maximize recovery, which threatens the fabric of the securities. The tendency is to move to foreclosure quickly. Congress is considering stepping in to protect loan services from investor lawsuits because of the risks of current economic conditions. Investors that hold these securities instruments have been advised to push for loan modifications, rather than complain about profitability.

Mortgage services have been quickly working to modify loans. It is being suggested that mortgage services lower or “writedown” principle amounts of loans to make the loan more affordable. Congress quietly stepped in with the Mortgage Forgiveness Debt Relief Act last December. Now, mortgagers can “writedown” loans, in effect, charging off the value of taxes on loan amounts to taxpayers. On the White House website, the sales pitch is “paying taxes on cancelled mortgage debt”, apparently a straw horse for the possibility of more radical measures in the immediate future. The purpose of the Act increases the incentive for borrowers and lenders” by allowing the industry to write off mortgage taxes owed to the government. The Administration has admitted that Congress has a lot more work to do. The Fed has implied that costs are a lot higher since the loans have been rolled into securities and resold to investors to generate investment sales. This action acts as a “stucco patch” to cover the cracks in the dam of financial crisis while Congress masterminds the ongoing moves necessary to cover the economy.

Lax lending rules started through mortgage finance companies. As business boomed, larger bank and thrifts eased credit standards and widened the scope of potential disaster. Many more rolled these loans into securities for additional profit. The Fed, as the new voice of financial propriety, is calling for more rules. Strangely, the banking rules were in place and yet were conveniently ignored and financial instruments creatively justified. Even the President publicly justified the fact that the rules were being ignored or “bent” as far back as 2004. The Federal Reserve recently posed the fact that there is “no regulatory regime that applies consistent, across-the-board standards to protect all borrowers”. The Fed has proposed “truth-in-lending regulations” in an effort to deal with the negative press toward the lending industry.
Change is clearly in the air. Don’t expect less government. Expect another regulatory agency or enhanced duties from an existing government agency. Expect higher costs. Expect the government to bail out everyone at taxpayer expense through the Federal Reserve. Expect more protective measures to be taken. Is a new currency a coming reality? Already, the Federal Reserve Bank of New York has voted themselves (through the FOMC) the authority to buy and sell securities and hold U.S. bonds. This power can be used to bolster, cover and perhaps favorably manipulate the marketplace and the economy at taxpayer expense.

In the past, downturns in the economy lead to problems in the banking and credit markets. As a result of lax lending policies or lax implementation of policies, the banking and mortgage arm of the credit industry is stressing the economy. The tail is wagging the dog.

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